Why the pursuit for ever-growing profit margins has opened the door to Square and other small business disruptors

In the last ten years, we’ve seen an onslaught of new competitors in the small business banking space. And it has only continued to grow. Traditional financial institutions (FIs) must contend with first movers -- big tech players and fintech challengers -- along with a wide range of business-focused neobanks.

Case in point: In 2020, we saw Square become a bank, Stripe Treasury offer embedded banking to a number of platforms, and Quickbooks unveil a small business deposit account. And 2021 has shaped up to be another busy year, with a seemingly endless procession of disruptive neobanks entering the market -- many explicitly targeting specific small business niches (e.g., freelancers, entrepreneurs, creatives, barbers!).

Despite their inherent diversity, all of these companies share a strikingly similar strategy when it comes to growth. To better understand what that is, we can turn to a concept that is widely recognized, but often misinterpreted: the theory of disruptive innovation.

How disruptive innovation helps us to better understand the current competitive landscape

At its core, the theory of disruptive innovation is intended to help established companies identify and mitigate disruption -- ideally before it takes hold -- so that the incumbent can continue to operate and grow.

The following definition comes from the Clayton Christensen Institute, founded on the theories of Harvard professor Clayton Christensen:

Disruptive Innovation describes a process by which a product or service initially takes root in simple applications at the bottom of a market — typically by being less expensive and more accessible — and then relentlessly moves upmarket, eventually displacing established competitors.

Importantly, disruptive innovation takes time, as entrants introduce products to the market that are never as good as the current products and services -- at least not initially. However, these disruptive offerings provide other desirable benefits, such as convenience, ease-of-use, affordability, and simplicity.

Once entrants gain a foothold at the bottom of the market, their product(s) will often undergo refinement and improvement, until they can meet the needs of the majority of customers in the mainstream. Established companies (incumbents) often ignore these competitors as they continue to move upmarket in a bid to capture higher profits. By the time they take notice of disruptors, it is usually too late.

Financial institutions continue to prioritize products built for commercial clients, as they abandon small and micro-businesses.

Historically, treasury management services like payment integration, disbursement solutions, payroll, and reconcilement have held an important place in an FI’s business lineup. And for obvious reasons, these varied services can be effective when it comes to helping larger enterprises and corporate entities boost operating efficiencies.

The primary need of a small business (SMB) is much more straightforward: to get paid. And secondly, to be able to manage their cash flow. Indeed, money is the lifeblood of any small business, and without an easy way to receive it and manage it, the reason why most fail.

According to a 2016 report from the JPMorgan Chase & Co. Institute, the median small business owner only had 27 days of cash in reserve. Detailed in the report is the tight correlation between daily inflows and outflows of cash for small businesses. This tight correlation highlights that any interruption in consistently bringing in cash can have a catastrophic impact on the health of a small business.

The problem is that most FIs lack the specific products and services that can help small businesses owners meet this basic needs. And the situation is hardly changing. 

Granted, most FIs want both small business relationships and commercial relationships. But in the inevitable tug-of-war that comes with prioritization, it’s typically the commercial customer base that gets the most attention. From a business standpoint, it makes sense. Commercial clients generate higher margins and less foot traffic -- while SMBs eat up finite resources.

Over time, we know that preferences simply become the way business is done. FIs have continued to set their sights up high -- toward bigger profit margins. In the process, they’ve mostly abandoned the bottom end of the market: specifically, micro- and small businesses. 

This customer preference may not be explicitly embraced by many FIs. However, a quick look at a representative sample of bank websites will bear out this reality. A small business owner seeking the right solution will encounter a bewildering assortment of commercial accounts and treasury management services -- along with the one requisite small business account. Unfortunately, the majority of these aforementioned products woefully underserve small business needs.

There are over 10,000 insured financial institutions in the U.S., and the vast majority of them have underserved small businesses by offering them essentially the same commoditized products they did ten years ago. And it is this very fact that has opened the door to disruption.

Small business has become too big a market to continue to ignore.

SMBs generate $850B of annual revenue for banks, a pool expected to rise sharply in the next seven years. The U.S. economy is further impacting the look of small business: independent workers now hover at 41 million adult Americans of all ages, skills, and income levels — consultants, freelancers, contractors, solopreneurs, temporary, or on-call workers — who work independently to build businesses, develop their careers, pursue passions, and/or supplement their incomes. Over the past year, independent workers generated roughly $1.28 trillion of revenue for the U.S. economy — equal to about 6.2 percent of U.S. GDP (2018), or the entire economic output of Spain.

In addition to full-time independent workers, more Americans are taking up a side hustle to supplement their income. In 2019, these occasional independents rose in ranks to 15 million. That number is up more than 40 percent since 2016. Over the next five years, we project 53 percent of the U.S. adult workforce will either be working or will have worked as an independent.

Want to learn more about the state of small business? We recommend the Autobooks Small Business Report 2020, available on Autobooks.co.

Enter the classic disruptive innovator: Square

In 2009, Square’s founders uncovered the basic need for small business owners to get paid -- and did something about it. 

As the story goes, artisanal glass blower and future Square co-founder Jim McKelvey needed a simple way to accept a card payment from a prospect, and realized later that this lost sale could become an opportunity. Soon thereafter, McKelvey partnered with friend and Twitter co-founder Jack Dorsey to start Square, and quickly introduced their remedy for an ongoing SMB pain point: the Square Reader.

Their idea was simple -- as many disruptive offerings tend to be. The dongle would be connected to a mobile device, effectively becoming a point-of-sale system. Moreover, the accompanying app, called POS, would facilitate the interaction between buyer and seller, making the product and service a mostly seamless and enjoyable experience.

As mentioned earlier, a disruptive technology at the outset is rarely superior to existing, competing products. The Reader was far from perfect. It hardly resembled the more robust card terminals of the time, and there were concerns about security that were soon addressed with future iterations. Nevertheless, the dongle was inexpensive to manufacture, and offered an entryway to a market teeming with underserved micro- and small business owners searching for a convenient and affordable solution to accept card payments.

Just six months after introducing its Reader, Square was processing millions of dollars in gross payment volume every week. By 2011, more than 100,000 new users were signing up for Square every month.

To review, step one in the disruptive process: The incumbent focuses on the high end of the market, neglecting the needs of down-market customers. This provides an opportunity for an innovator to gain entrance into the market -- even with a basic product that may be deemed inferior in some ways.

What about FIs during this time? Did they re-evaluate their SMB strategy, or introduce a similar product?

In step one above, we learned that incumbent businesses -- in our case traditional FIs -- typically focus on those customers that pay the most and invest their resources on those sustaining innovations that deliver the highest returns. This is simply a principle of good management. But it’s also the reason why so many incumbents fail. This is the paradox at the center of Christensen’s groundbreaking book, The Innovator’s Dilemma.

Amazingly, both financial institutions and major companies failed to see small business for what it was -- an underserved market in need of a solution to an ongoing problem. Any number of competitors at the time, especially business banks, could have introduced a similarly affordable card acceptance product like Square’s, unlocking a vast opportunity for additional revenue streams. None did.

Like all disruptors, Square didn’t stop with its Reader. After all, an important component to disruption is the ability of the entrant to refine and expand its products in order to attract a more general, mainstream audience. Square focused on continuing to solve problems as they expanded their small business product offerings. The ability to accept card payments was a huge challenge -- but only the first!

To learn more about the later steps in the process of disruptive innovation, and how Square has closely followed this model as it continues to grow, be sure to read the upcoming Autobooks Guide to Disruption in Small Business Banking.